Secrets to Keeping the IRS Out of Your Clients’ 401K

At some point in the future, your financial coaching clients will no longer be working where they are. Whether it’s because they retire, get laid off or change employers, it’s your responsibility to prepare them. That’s because when it comes to their pension funds, they have several options open to them when they leave their job. And if you don’t know what those options are, and choose the wrong one, you will have the IRS smack dab in the middle of your clients' IRAs. This means your clients chances of having the opportunity for long-term tax deferred wealth building become very slim.


Option 1: Taking a lump-sum distribution (cash out)

Off the top, your clients will lose 20 percent of their accumulated money because their employer is required to withhold this amount for federal taxes. Cashing out your clients’ retirement plans is counted as receiving ordinary income, and depending on your clients tax bracket (ordinary rates now reach 35 percent), they may end up owing even more than that 20 percent, and that does not include the state taxes that may apply as well.

Furthermore, if your clients are younger than 59.5 (age 55 in some limited cases) they will be penalized for an additional 10 percent off the top. So, our old pal Uncle Sam just slashed the retirement savings your clients have accumulated for their Golden Years by a third or more!

Avoid this entirely. (In fact, it’s difficult to even think of it as an “option.”)

For Example, Dan, age 50, left his job. He had $100,000 in his employer's 401(k) plan. Dan decided to take the money from the plan and open a self-directed IRA account. As a result, Dan's former employer sent him a distribution check for $80,000 -- Dan's $100,000 account balance, less 20% withholding. To avoid all income taxes and penalties, Dan must not only deposit the $80,000 check within 60 days of the distribution, he also must deposit $20,000 (the amount withheld by his employer) by that same date. The $20,000 must come from sources outside of the distribution. If Dan does not have $20,000 from other sources, that amount will be treated as a distribution and will be subject to income taxes and penalties.

Sure, Dan will get this $20,000 back in the form of taxes withheld when he files his tax return, but that could take a number of months. Why go through this hassle when using the correct transfer method will avoid the 20% withholding, and will not make your clients scramble to find funds to cover the withholding amount?

Build Your Clients Wealth and Help Them Retire Financially Secure With Your 3 Other Options

Your other options include (1) leaving your clients’ money with their former employers plan; (2) rolling it over to their new employer; or (3) rolling it over to an IRA.

Each of these options will help keep the IRS out of your clients’ IRA, if you choose wisely and follow all the rules, which can be complex. However, there is more to consider than merely the tax implications. What about growth? Safety? The next Enron?

Retire Financially Sound or Retire With Debt – It’s Your Responsibility To Help Your Clients Make The Right Choice

So, in conclusion, taking a lump-sum distribution (cash out) from your clients’ 401K means that all the money they withdraw will be subject to income tax at ordinary income rates that now reach 35%. What’s more, if they leave their job before age 55 they will probably owe a 10% penalty on top of the ordinary income tax, leaving you with no deferred wealth building opportunities for your clients and their families.

Avoiding all the pitfalls and dangers can be accomplished by choosing the right kind of rollover for their IRA, based on their specific, individual and unique situations.

Remember, this is your clients’ retirement nest egg. The better they can protect it and invest it, the farther along the road to a glorious retirement they will find themselves.

Written by Paul Hooper, President of Marketracker Capital Management, Inc.

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